December 10, 2016

The decision made by the Indian government recently to demonetise Rs. 500 and Rs. 1,000 currency notes led to rumours that Pakistan would also scrap higher denomination currency note and prize bonds of Rs. 5,000 and Rs. 40,000 value respectively. The rumours soon triggered conversion of domestic currency into dollars. The State Bank of Pakistan and the Finance Ministry repeatedly conveyed the message to the general public that the government did not have any such plan in mind. However, Prime Minister Nawaz Sharif had frozen foreign currency accounts worth $11 billion during a previous stint in power, which perturbed deposit holders. Several quarters changed their rupee holdings into the dollar which surged sharply by over Rs. 1.30 to 107.60 in the open market.

There is a general perception that most businessmen in Pakistan have been using cash to conduct their daily business affairs over the last year. They shied away from parking their funds at the banks because of the government’s move to deal with an iron hand with those not paying taxes, considered to be non-filers. During the fiscal year 2014-15, the government came out with the plan of imposing 0.4 per cent withholding tax on cash withdrawal of above Rs. 50,000 for filers and 0.6 percent for non-filers. This resulted in stiff resistance from the business community. The government did not withdraw the tax, but eventually reduced it to 0.4 percent for non-filers, while abolishing it for filers.

Since then, to avoid the Federal Board of Revenue’s clutches, many businessmen have conducted transactions on a cash basis, a view endorsed by the State Bank of Pakistan’s (SBP) recently released annual report. “Another complication that has emerged for SBP’s monetary management is a sharp slowdown in deposit mobilisation, in spite of acceleration in the pace of money creation in the economy. Instead of deposits, it seems that public preference has shifted in favour of currency,” the report said.

Effectively, what this implies is that though the pace of money supply growth has increased in the economy, less money is now coming back into the banking system. This, in turn, suggests that more economic transactions now involve out-of-bank settlements. While the continued vibrancy in the informal economy partly explains this trend, the general public has now become more inclined towards using hard cash for the settlement of formal transactions, according to the SBP annual report.

One reason for lower preference for bank deposits is the imposition of withholding tax of 0.4 percent on non-cash banking transactions (cross-cheques, demand drafts, pay orders, etc.) undertaken by non-filers. The business community has serious apprehensions over this measure and has repeatedly requested its withdrawal. It is important to recall here that business sector deposits, which constitute nearly a third of total (non-government) bank deposits, are used primarily to facilitate their voluminous transactions. Therefore, a tax on these transactions over and above usual business levies (like income tax, sales tax, FED, etc.) is surely an added burden. Hence, it is not surprising to see the growth in business sector deposits dropping quite sharply in FY16, the SBP elaborated.

The action taken by the Indian government to trail black money and cash gathered through corruption was taken by a cabinet that remained tight-lipped for six months. In our country, on the other hand, members of both the lower house and upper house would strongly oppose such measures. If they were taken, they would be the first to convert deposits into dollars or transfer their ill-gotten money through hundi and hawala, despite the fact that these tools have also been declared illegal.

Though the Indian government has argued since November 9 that demonetisation had to be declared to curb the movement of black money in the economy, reports emanating from the neighbouring country are horrifying in terms of the picture they paint of human suffering. More than 33 deaths have surfaced, most of those who were holding their earnings for a daughter or son’s marriage, or are pensioners and widowers. Above all, daily long queues were witnessed across India to change currency. The scrapping of Rs. 500 and Rs. 1,000 currency notes was like an earthquake for the citizens of India. According to an estimate of the Reserve Bank of India, circulation of both currency notes values around 224 billion dollars, equivalent to Indian Rupees 15 trillion, while they constitute around 86 per cent of currency notes in circulation.

The ripples of demonetisation were also felt in Pakistan where frequent travellers and small business men trading with counterparts have holdings running into millions. They have been stumped by the decision as exchange companies have stopped trading in Indian currency, while a few money changers entertain their customers at a 40 to 50 percent discount, i.e. giving a Rs. 500 rupee note in exchange for a Rs. 1,000 Indian note.

Zeeshan Afzal, director research at Insight Securities, said that the demonetisation, if undertaken in Pakistan, would also be intended to flush black money out of the system. Eliminating undocumented currency discourages black money and holding of cash outside the banking system while it encourages banking penetration and helps more money to get into circulation. It has its loopholes, for instance, black money holders could rush to convert their cash into gold or dollar holdings as soon as they get an inkling of the scheme.

Afzal says such measures could be undertaken in Pakistan, but the government seems to prefer to go for amnesty schemes, such as the largest ever scheme offered to the real estate sector. Already, existing black money can either be whitened or turned to zero through such schemes, which seem to discourage legitimate business dealings, providing an easy way out for black money. Afzal says that cash transactions above a minimum level should be banned and all real estate transactions should be through banks alone. Anyone found with large cash piles, legal or illegal, should be punishable under the law, as in England.

One could easily gauge that a large amount of untaxed funds are parked in prize bonds in Pakistan. According to the recent SBP report, as of June 30, 2016, about Rs. 646 billion worth of prize bonds have been issued. If we take a quick look, about Rs. 183 billion worth of Rs. 40,000 prize bonds have been issued, Rs. 112 billion worth of Rs. 15,000 prize bonds, Rs. 93 billion worth of Rs. 25,000 prize bonds and Rs. 71.7 billion worth of Rs. 7,500 prize bonds. The numbers of Rs. 5,000 notes in circulation is not available, but with the size of money in circulation amounting to Rs 3.6 trillion, if Rs. 5,000 notes amount to 20 per cent, it means the circulation adds up to Rs 720 billion. So if Rs. 5,000 notes, Rs. 40,000 prize bonds and Rs. 15,000 prize bonds are added on, we assume that untaxed money of nearly Rs. 1 trillion has been hidden away.

Taha Khan Javed, Director Research at Alfalah Securities, remarks that demonetisation, on the face of it, seems like a good idea as it weeds out fake currency and puts corrupt officials at a disadvantage, but the jury is out on whether it fulfils its purpose since the experiment has been tried in other countries with limited impact. The majority of small businesses and the agriculture belt transact in cash and may become cash-strapped with demonetisation, hurting business and consequently revenue, employment, consumption and investment. The informal sector employs the majority of workers and most transactions are in cash. Disrupting this system could endanger the employment and livelihood of weaker sections of society.

One impact of demonetisation measures would certainly be slower economic growth. As most real estate transactions entail an element of cash, this market is likely to come to a standstill with property prices likely to fall. This would imply a negative-wealth effect, leading to a decline in consumption and possibly business investment.

In Pakistan, as in India, there is widespread corruption and hordes of black money, but much of it is not held in cash but in various asset classes such as the US dollar, gold, prize bonds and, most of all, real estate. The best way to go after black money is to look at the consumption patterns and lifestyles of people and compare it with their annual tax returns. This can easily be done and some effort was made by NADRA, although it was not wholehearted. Unless we have an independent and strong judiciary, we cannot expect to ever hold the dealers in black money accountable.